USING AUCTIONS TO ALLOCATE AND PRICE LONG-TERM CREDIT

Most long-term credit in developing countries is allocated through negotiated agreements between government institutions and financial intermediaries or final borrowers, and often at administered rates. Yet many developing countries have no long-term credit market whose interest rates can be used as benchmarks for these loans. If credit is priced improperly, it will be allocated inefficiently and the development of capital markets may be stunted. In light of the generally disappointing experience with conventional methods of allocating development credit, some countries have introduced credit auctions as an alternative. Among the advantages are greater transparency and fairness, lower transaction costs, and increased competition and efficiency. Among the disadvantages are a greater vulnerability to collusion, which can lead to lower interest rates and revenue, and a tendency to attract the least desirable participants (adverse selection) and to lend for riskier projects (moral hazard), which can lead to lower repayment rates and a higher probability of default. All these factors can lead to inefficiency in the allocation of funds. This article suggests ways to lessen these negative effects and presents various elements of auction design that affect the efficiency of credit auctions and their suitability to specific circumstances. When properly designed, auctions can be used in a variety of environments to allocate development credit more efficiently than current methods do.